Suppose Justice Settles With Apple and Publishers. Then What?

Apple and its partners in the publishing industry are in a heck of a fix. They don’t want to rip up their business agreements and start over again. They really don’t want e-book pricing to be driven by Amazon. But they stand to gain nothing by litigating an antitrust case with the U.S. Department of Justice. Even if they win, it’ll burn through cash and will earn them nothing but bad press. And if they lose, the entire structure they’ve built for pricing and selling e-books will likely come tumbling down.

“Apple simultaneously introduced a transition from wholesale pricing in e-books to agency pricing, including a most favored nation clause, among a small group of publishers. Regardless of what actually happened, that looks almost identical to what would be an agreement between the publishers themselves,” says Donald Knebel, an antitrust lawyer affiliated with Indiana University’s Center for Intellectual Property Research.

“Both sides think that they have the arguments to win, but neither side is 100% convinced,” Knebel adds. “It makes sense in this period of uncertainty, before the messy discovery process, to avoid litigation if they can.”

Any settlement, he adds, would almost certainly require no admission of guilt by any of the parties, and would have no legal implications for either the class-action suit against Apple and five of the Big Six trade publishers or a similar investigation happening in Europe. It would simply resolve this investigation and any uncertainty as to its outcome.

This is why it’s no real surprise to read reports that Apple and five of the Big Six trade publishers are actively discussing settlement agreement with the DoJ and at least some of the parties are close to an agreement. The only questions (besides how close all of the different parties actually are and whether the whole thing may still fall apart) will be the details of that potential agreement and the consequences of those details for the still-forming digital publishing industry.

Eliminating the “most favored nation” clause between Apple and the five publishers, which guarantees that the publishers cannot sell e-books at other retailers at prices lower than those offered in Apple’s bookstore;

Temporarily pausing or modifying agency relationships between publishers and retailers. The WSJ’s sources call this a “cooling-off period.” The intent would be to ensure that any new agreements would be negotiated at arm’s length, unlike the initial simultaneous move to agency and price maintenance in 2010 — which raised concerns that the publishers illegally coordinated their actions.

The WSJ further adds that three of the publishers — Simon & Schuster, HarperCollins and Hachette — are inclined to settle on these terms. Apple, Penguin and Macmillan are not.

What the heck is a cooling-off period?

On Twitter, I compared this to the Justice Department telling publishers to “go take a lap and think about what they did wrong.” It’s kind of a weird idea, but not without precedent in antitrust investigations. It suggests that DoJ thinks there was something fishy about agency pricing, but doesn’t want to prohibit or fundamentally change it in e-books outright.

This was a problem for several reasons, not least of which was the fact that, as FTC commissioner Robert Pitofsky later said, “over 40 percent of programming would have been integrated by full or partial ownership with two cable companies that collectively controlled over 40 percent of cable distribution in the United States.” The agreement appeared to help both Time Warner and TCI way too much at the expense of their competitors — Time Warner by locking in carriage deals for its top content, and TCI by securing that content at a discounted price.

The FTC recommended several changes to the acquisition deal, most of which were implemented, before it approved the merger in 1997. An important one was cancelling the carriage agreement between Time Warner and TCI, limiting the length of any future agreement to five years rather than twenty, and mandating that the two parties had to wait six months until after the merger to negotiate a new agreement.

This is the “cooling-off period.” The idea was to make clear that the carriage agreement was not part of a tit-for-tat agreement tied to the acquisition, but a separate negotiation between companies with distinct interests and incentives. As far as I can tell, that’s the best precedent for what the DoJ would like to implement between e-book publishers and Apple — not a transformation of their agreements as such, but a shift in their timing.

It gets complicated in several ways. First, Apple does not want to be a wholesale purchaser of e-books, even for six months or a year. It doesn’t want to price e-books, and it doesn’t want to bear the risk that e-books don’t sell. It’s not equipped for that.

Second, if the concern is simultaneous moves by publishers to negotiate new contracts with retailers, it seems like a weird solution to tell publishers to wait six months (or whatever) — at which point they will all again negotiate new contracts with retailers. Will the DoJ try to stagger those negotiations? How will that work?

It’s understandable that some publishers would be willing to accept that to get this done, but equally understandable that others would be highly suspicious. It’s likely that everyone would rather drop the most favored nation clause and call it a day.

E-Books without Most Favored Nation

“You can have an agency agreement without a most favored nation clause,” says Knebel. “But you can’t have most favored nation without agency. If you eliminate agency, most favored nation goes with it.”

What would it look like to leave the agency model and retail price maintenance intact, but eliminate Apple’s MFN provision in its contract with publishers? Smashwords’ Mark Coker, one of Apple’s early partners in iBooks, told me this would leave things mostly as they are, with retailers and publishers free to negotiate wholesale and agency with whomever they please.

The only difference would be that publishers in Apple’s iBookstore would no longer be able to say to Amazon, Google or any other retailer, “we can only negotiate with you on an agency basis, because our contract with Apple prohibits us from letting you set prices for our books.” Why might giving that up be enough for the Justice department?

MFN is one of the things that raises the suspicion that Apple served as a hub in a hub-and-spoke conspiracy. You could argue that by insisting that all publishers in the iBookstore agree to an MFN clause, Apple was effectively transmitting information between the publishers that allowed them to coordinate their actions with both Apple and Amazon.

Blue Cross Blue Shield of Michigan (BSBSM) used MFN provisions in its contracts with at least 70 of Michigan’s 131 general acute care hospitals, with the effect of raising hospital costs for competing health plans and reducing competition for health insurance:

The department said that the MFNs require a hospital either to charge BCBSM no more than it charges BCBSM’s competitors, or to charge the competitors a specified percentage more than it charges BCBSM, in some cases between 30 and 40 percent. The complaint alleges that BCBSM’s use of MFN provisions has reduced competition in the sale of health insurance in Michigan by raising hospital costs to BCBSM’s competitors, which discourages other health insurers from entering into or expanding within markets throughout Michigan. The complaint further alleges that BCBSM agreed to raise the prices that it pays certain hospitals to obtain the MFNs, thus buying protection from competition by increasing its own costs.

Now, if the DoJ’s characterizations of BSBSM are accurate, Apple’s agreements with publishers (and vice versa) were not nearly as sharp as BSBSM’s with hospitals. No one has said Apple insisted it pay less for e-books than its competitors, nor did Apple have the position in the U.S. e-book market that Blue Cross had in health insurance in Michigan. But it does suggest that the DoJ is interested in investigating and possibly litigating antitrust cases involving most favored nation clauses when they appear to have disproportionate industry-wide impact.

Eliminating the most favored nation provision might be the easiest way for Apple and the publishers to dodge antitrust concerns, whether or not they can convince the DoJ to drop its insistence on a “cooling-off period.” But this is where it gets interesting for two reasons:

Apple uses most favored nation clauses in a lot of its contracts — for instance, with magazine and newspaper publishers. Is the DoJ worried about antitrust concerns there, too?

A settlement, as opposed to a decision in federal court, means that the consequences of eliminating MFN are contained to this specific industry and to the publishers’ agreements with just one retailer.

That’s another incentive for everyone to settle, before the implications for the entire digital marketplace spiral out of control.